Blood can be thicker than water in your search for startup capital funding. Family and friends can be a great source for bootstrap financing. They’ve got a vested interest in your personal success, and they may be willing to take a chance on you that no bank would. But with loved ones, you’ve got to structure any financing for your small business very carefully – and understand that the future of the relationship may ride on the success of your new venture.
You’ve got a great idea for a startup business, and you just need a few thousand dollars to get it off the ground. But you’re pretty strapped right now, yourself.
Who ya’ gonna call? Mom and Dad! Your old college roommate, the corporate lawyer! Or maybe even your brother, who really should be investing in your business instead of buying 50 lottery tickets every week.
In turning to family and friends for some help starting your business, at least you’ll be in good company: a staggering 87% of private financing for startup businesses comes from relatives and friends of the entrepreneur, says the Global Entrepreneurship Monitor, a research outfit at Babson College.
But there are good reasons why some people call this form of business financing the “family, friends and fools” approach.
Here are our seven tips for tapping into family and friends for the dough you need to startup your business – without getting yourself “un-invited” to Thanksgiving dinner:
- Understand their motives
- Come up with a “kitchen-table pitch”
- Make it a loan, not an investment
- Focus on a repayment plan
- Draft an official loan agreement
- Consider lining up one person as a backstop instead
- Do a gut check before going ahead
Understand their motives
The vast majority of family and friends who will contribute financially to your startup are motivated mainly by the desire to help you out – that’s it! Of course, another significant motivating factor could be that they see your small business as a decent investment. Either way, it’s crucial for you to understand their motivations, because it will appropriately color how you approach obtaining business financing from them.
Come up with a “kitchen-table pitch”
We talk about “elevator pitches” all the time here at StartupNation. Come up with something similar that you can present to family and friends: what has been termed a “kitchen-table pitch” by Asheesh Advani.
“Look them in the eye and say, Here’s why this business idea will work, and here’s what I’m going to do to make it work,” says Advani, CEO of CircleLending, a Waltham, Mass.-based outfit that arranges loans between entrepreneurs and family and friends. “And if it doesn’t work, here’s my back-up plan. I’m going to find a way to pay you back even if the business doesn’t work. The key is to be brutally honest about the business, because these relationships are important to you.”
To really ensure that your loved ones understand the investment opportunity, play show-and-tell. If possible, load up your kitchen-table pitch with audio-visual aids. If you’re talking about making a product, bring out a physical representation. If it’s a service business, practice your sales pitch in front of them. Load up your presentation with newspaper articles and other things that underscore the potential market you’re describing to them, and provide them with a copy of your business plan.
Make it a loan, not an investment
It’s best if you make it clear that the $5,000 you’re collecting in a crinkled check from Cousin Suzy is just a loan and that you’re going to pay it back – it’s not an equity investment. She’s entitled to get back what she fronted you, with interest, but her participation doesn’t mean she’s bought a piece of your startup company.
It may be easier for you to solicit capital from family and friends if you arrange it as equity, but in most cases you should still steer away from that idea. “Even if your business becomes successful, 99% of the businesses in America have no liquidity,” Advani says, “so someone having equity in your business has no value. Uncle Joe couldn’t sell his piece of your business, for a whole bunch of reasons.” Not to mention that you may not want Uncle Joe weighing in on how you run your business, which is precisely what you’re entitling him to do by accepting his money as an equity investment.
Instead, give your loved ones the glimmer of a greater reward from your business if it really takes off: a bonus that you pay them upon reaching a certain level of success, in addition to paying them the original loan amount.
Focus on a repayment plan
This is the crux of whatever deal you make with family and friends: How in the heck are you going to make sure you pay them back? The answer is to formulate a repayment plan that lines up with your business plan (especially your cash flow projections), and come up with a reasonable and easy-to-understand interest rate. Put the plan on paper, maybe even get a lawyer’s help in drafting it. But make the schedule friendly to yourself and your venture. No one wants to see the company fail a year later because of a requirement to repay these loans!
You might suggest, for example, no payments for the first year; interest-only payments for the next two years; and, after that, an amortized schedule to pay back interest and principle over the next two to five years, Advani suggests. Also be smart enough to work in factors that might be specific to your type of small business: For example, restaurant traffic is often seasonal, so have each year’s repayment schedule reflect that.
A word of caution: Don’t fall into the lump-sum trap. The biggest mistake that entrepreneurs and their family and friends often make in arranging for repayment of the loan is to say something like, “OK, then, I’ll pay you back the $25,000 at the end of three years.”
“That’s the worst way you can get capital,” Advani advises. “Three years roll around and you discover that very few people have the discipline to be prepared to make a lump-sum payment.”
Draft an official loan agreement
Once you’ve settled on a repayment plan, you (or your attorney) should draft an official loan agreement to protect both parties and ensure that everyone understands this is business, not personal. If you’re drafting the agreement yourself, think about including issues such as:
- Term of the loan
- Payment amount
- Payment schedule
- Interest rate
- How to handle potential early repayment
- How/when the loan will be paid if the business fails
- How to handle late or missed payments
- Any bonuses you plan to pay (optional)
- Any special payment arrangements, such as no payments for the first year, interest-only payments, seasonal payments, etc. (optional)
Once the agreement is in place, keep your loved ones informed on a regular basis, just as you would with a board of directors, about your progress – or lack thereof. Put together a simple, written quarterly report assessing where you are with your startup business.
Consider trying to line up one person as a backstop instead
An alternative approach to going to family and friends up front is to line up two or three loved ones who have the most resources only as a last resort. That way, they participate in your venture, in a sense, but you hope without having to actually cough up any funds. For example, secure the promise of up to a six-figure bailout from a well-to-do friend – just in case you ever need it.
Do a gut check before going ahead
As attractive as that stack of $2,000 checks from your circle of friends might be, you must perform the grittiest gut check that you’ve ever done before deciding to go ahead and cash them.
Are you going to be able to fulfill the promises that you made to all of your hopeful supporters? Is everyone clear on the amount, timing and circumstances of repayment? If your small business fails, can you still not only look them in the eye but also break bread harmoniously with them once again? If you can’t answer a resounding yes to each of these questions, you might want to go back to the drawing board.
Our Bottom Line
If you need startup funds from family and friends, you’re in pretty common company. And if you present your small-business idea clearly to them, stress that their support is only a loan, create a realistic repayment plan and make the loan official, you‘ll be taking the right steps to protect your relationships. But stay away from this form of bootstrapping if you can’t come up with a workable repayment plan -- it could make the rest of your life miserable.